Bp is mainly determined by ka y m ca 0 r rd rf ka 0

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BP is highly interest elastic. BP is mainly determined by KA. y ↑, M↑, CA < 0r↑, rd > rf, KA > 0 BP > 0 (Point B), DDfe↓, e ↓ (domestic currency appreciates, foreign currency depreciates)X ↓ , M ↑, IS ↓(IS1 shifts left to IS2), BP ↓ (BP0 shifts left to BP1), y ↓ (y1 to y2), r ↓(r1 to r2), from point B to COverall: y ↑ (y0 to y2)r ↑ (r0 to r2)e ↓(domestic currency appreciates)BP = 0 (point C), IB=EBConclusion: Under flexible exchange rate system, fiscal policy is less effective when BP is vertical (high capital mobility)
IS1LM0IS0BP0r0r10Y0rYACase 4: Flexible Exchange Rate Horizontal BP Curve (Perfect Capital Mobility)Fiscal Policy BY1(BP > 0)Initial: At point A, IB = EB (Intersection IS-LM and BP), BP=0, rd = rfG ↑, IS ↑ (IS0 shifts right to IS1), y↑ (yo to y1), r ↑(r0 to r1), from point A to BBP is perfectly interest elastic. BP is fully determined by KA. We focus on the effect brought by ↑ in rr↑, rd > rf, capital inflow ↑, KA > 0, BP > 0 (point B, IB > EB)BP > 0 (Point B), DDfe↓, e ↓(domestic currency appreciates, foreign currency depreciates)X ↓, M, IS ↓ (IS1 shifts left to IS0), y ↓ (y1 to y0), r ↓ (r1 to r0), from point B to AOverall: y remains unchanged at y0r remains unchanged at r0e ↓(domestic currency appreciates)BP = 0 (point A), IB=EBConclusion: Under flexible exchange rate system, fiscal policy is not effective when BP is horizontal (perfect capital mobility)
Flexible Exchange RateMonetary Policy
Monetary Policy with No Capital MobilitySince there is no capital mobility, BP curve is vertical. There is no role for capital account and BP is only affected by current account.Initial equilibrium at A(Ro,Yo) internal balance=external balanceExpansionary MP ↑MSshift LM curve to the right (LMo→LM1)equilibrium point changes from A to B(R1,Y1)achieve internal balanceAt point B, it suffers BOP deficit Income↑ from Yo to Y1 increases the imports (m=f(Y))Increase in imports causes trade balance deficitPeople demand more foreign goodsDemand for foreign currency↑Domestic currency depreciates, exports increaseIncrease in exports shifts IS curve to the right (ISo→IS1)Since domestic currency depreciates, BP curve shifts to the right (BPo→BP1) until to the interception of LM and IS at point C with R2 and higher income Y2In this case, monetary policy is effectiverY
Monetary Policy with Low Capital MobilitySince there is low capital mobility, BP curve is steeper than LM curve, more influence by current accountInitial equilibrium at A(Ro,Yo) internal balance=external balanceExpansionary MP ↑MSshift LM curve to the right (LMo→LM1)equilibrium point changes from A to B(R1,Y1)achieve internal balanceAt point B, it suffers BOP deficitIncome↑ from Yo to Y1 increases the imports (m=f(Y))Increase in imports causes trade balance deficitPeople demand more foreign goodsDemand for foreign currency↑Domestic currency depreciates, exports increase.Increase in exports shifts IS curve to the right (ISo→IS1)Since domestic currency depreciates, BP curve shifts to the right (BPo→BP1) until to the interception of LM and IS at point C with R2 and higher income Y2In this case, monetary policy is effectiverY

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